Which should come first: paying off debt or saving? Many financial advisors recommend people in their twenties save 15% of their income, but simple math suggests getting rid of debt (particularly high-interest debt) is better for your financial health.
The interest rate on a savings account is now between 2% to 3.75% APY, while the interest rate on credit card debt could be over 20%. The choice seems obvious, but the decision to save or pay off debt can be complex in reality.
Below, you’ll find three perspectives to consider when deciding to save or pay off debt.
1. Set aside funds for unexpected expenses
It’s not a question of whether you will have unexpected expenses, it’s a question of when and how much. If you have no money saved, you run the risk of falling further into debt when emergencies arise.
Without any savings, a $500 charge to a 17% interest credit card would cost $659, and take 3 years and 7 months to repay if you were making only minimum monthly payments.
Establishing an emergency fund, even a small one, can help reduce the likelihood of falling deeper into debt. By setting aside just $2 a day, you can save over $700 by this time next year. Having an emergency fund can provide a financial cushion in case of unexpected expenses.
2. Develop good savings habits early
Studies show that people who develop positive financial habits early in their lives are more likely to make smart financial decisions as they grow older. Even while you’re paying off debt, consider getting in the habit of saving small amounts at the same time. Once you’re debt-free, preserve your habit by continuing to make periodic payments into a savings or investment account.
While paying off debt is certainly good for your financial health, debt only represents a piece of the financial equation. Building savings and investing in productive assets matters a great deal as well. If you’re devoting all of your focus on debt, it can be more difficult to develop good saving habits later.
3. Harness the power of compound interest
If you wait too long to start saving, it can be very difficult to make up the difference later on. The reason: compound interest.
Forbes illustrates the power of starting early by depicting four savings scenarios over a 40-year period.In each case, $1,000 is invested at the start of each month in a diversified investment portfolio.
The most dramatic difference is between Case 3 and Case 4 in the Forbes article , but the power of compounding is best illustrated by comparing Case 1 and Case 4. Both invested the same amount of money for 20 years, but because Case 1 started saving early the account continued to earn interest for 20 years and would be worth over $4.5M, while Case 4’s would be valued at $469K.
The bottom line on saving vs. paying down debt
Both saving and paying off debt can have a positive impact on your net worth, as it is calculated by subtracting your liabilities from your assets. Therefore, any action you take to increase your assets or decrease your liabilities will have a positive impact on your net worth.
Remember, your worth as a person is not defined by your finances or credit score alone. Taking small steps towards improving your financial well-being can have a compounding effect over time.